The current consensus in the profession is that exchange rates and macroeconomic fundamentals are disconnected at business cycle frequency. Recent work has shifted towards attempting to explain exchange rates using financial variables/shocks.
This research revisits the “exchange rate disconnect” debate using a rich data set of macroeconomic surprises/news and by allowing for econometric specifications featuring deviation from FIRE. It further traces the connection between macro fundamentals and exchange rates through a novel estimation of a well-known exchange rate decomposition that incorporates survey forecast data.
The research shows that high-frequency macroeconomic surprises explain, on average, about 70 percent of the variation in quarterly nominal exchange rate changes. Surprisingly, lagged macro surprises are much more important than contemporaneous ones, explaining almost all of the quarterly exchange rate change variation. Macro surprises are even more important for currencies of major financial centres, and during US recessions and periods of financial turmoil. Moreover, excess returns/currency risk premia are also mostly driven by macroeconomic news (over 50 percent of variation).